Contributed by Sara Coelho
A group of affiliated real estate developers enters chapter 11 and proposes a plan that would allow them to continue developing and selling properties in a residential subdivision in Lehigh County, Pennsylvania. The debtors estimate that the continued development of the subdivision will allow them to repay their secured creditors in full and even make a distribution to unsecured creditors. Sounds like a bankruptcy happy ending, right? As Heritage Highgate demonstrates, not necessarily. The chapter 11 plan hit a snag when the unsecured creditors’ committee challenged the secured status of a subordinated group of lenders, arguing that the value of the lenders’ collateral, as of confirmation, was insufficient to justify treating them as secured creditors, notwithstanding that the debtors’ planned sales of the lenders’ collateral were projected to generate revenues sufficient to pay the secured creditors’ claims in full. The bankruptcy court agreed, as did both the District Court for the District of New Jersey and the Court of Appeals for the Third Circuit. As a result, the lenders’ claim was found to be unsecured.
In Heritage Highgate, the debtors took out construction loans from banks, as well as additional loans from private investors. All the loans were secured by pari passu liens on substantially all of the debtors’ assets, but the investors’ claims were subordinated to the bank lenders’ claims under an intercreditor agreement. Together, the amount due on the loans totaled approximately $13.4 million at confirmation (composed of approximately $12 million in bank loans and $1.4 million in investor loans). This was less than the $15 million appraised value the debtor offered at the outset of the case in connection with a contested cash collateral hearing.
After the debtors proposed their chapter 11 plan, though, the unsecured creditors’ committee challenged the value of the investors’ secured claim, arguing that the claim should be rendered entirely unsecured because property sales since the time of the initial appraisal had reduced the value of the debtors’ project to approximately $9.5 million. The lower figure was supported by the original appraisal, but was adjusted for approximately $5.5 million in sales that occurred during the case, the proceeds of which were used to fund operations and repay some of the bank debt. Accordingly, the committee argued, the value of the collateral was less than the amount of the bank lenders’ $12 million claim, and, therefore, it did not support secured status for the subordinated investors’ secured claim. The bankruptcy court agreed with the committee’s motion and determined that the investors only held an unsecured claim that would share recoveries with other unsecured creditors. Both the district court and then the Third Circuit upheld that decision.
In reviewing the lower court opinions, the Third Circuit first held that it would only require a party challenging a creditor’s secured status to offer “sufficient proof” that the value of the collateral was less than the amount of the creditor’s claim. If the party met this standard, the burden shifted to the secured creditor to prove, by a preponderance of the evidence, that the value of the collateral supported its secured claim.
The committee met its burden by relying on the debtors’ appraisal, but the investors argued that the court should assess a value based upon the cash that the debtors would generate over time as they sold the properties, which was reflected in the projections supporting the plan. The investors argued that the mandate in section 506(a) of the Bankruptcy Code to determine value in light of the “proposed disposition and use” of collateral required the court to consider the debtors’ plan to develop and sell the investors’ collateral, including the expectation that the collateral would be worth more than the combined claims of the bank lenders and investors when the plan was implemented. The Third Circuit rejected this equation of a business valuation with plan projections, the purpose of which was to show that the debtors’ plan could be feasibly implemented. It held that section 506(a) of the Bankruptcy Code requires a court to determine the division of a claim into secured and unsecured portions as of confirmation and that projections “do not equate to ‘value’ as of the confirmation date because they anticipate Debtors spending time and money to realize value at a later date.” The court also found that, in valuing collateral that the debtor intends to use to generate income, the present value of the income stream would equal the collateral’s fair market value and that a determination of a property’s fair market value or replacement value was “respectful of a property’s anticipated use” and therefore satisfied the Bankruptcy Code’s requirement that the valuation account for the proposed disposition and use of the collateral.
The investors further argued that valuing their collateral at zero, when future sales were projected to generate cash in excess of their claims, amounted to impermissible “lien stripping.” In the chapter 7 context, there is authority that holds that judicial determinations of collateral value may be trumped if a foreclosure sale generates proceeds in excess of that value. The court held that application of this concept is not appropriate in the chapter 11 reorganization context, however, where the Bankruptcy Code contemplates future use and disposition of collateral by the debtor. It held, “The distinction makes sense: Chapter 7 liquidation proceedings involve the sale of liened property; Chapter 11 reorganizations involve the retention and use of that property in the rehabilitated debtor’s business.”
The logic of the opinion is straightforward, but the results are disturbing from a secured creditor’s point of view. How can a creditor, fully secured at the point of a contested cash collateral hearing early in the case, end up with an unsecured claim under a plan? The opinion does not offer a conclusion, but the facts in the opinion reflect that the use of proceeds of interim property sales to fund operations allowed for the value of the collateral to dip below the value of the debt while the project was being built. While this may be acceptable from a business perspective if one has confidence in projected cash flows, it compromised the investors’ security interest at a critical juncture in time. It also suggests that the investors had arguments that their security interests were not adequately protected when the debtor used and sold their collateral during the reorganization, which might have supported arguments against continued sales of the property during the case, or for modifying the stay to allow a disposition outside of chapter 11. If adequate protection had been granted, and yet the investors’ security interest was still compromised, the investors may have had a superpriority claim under section 507(b) of the Bankruptcy Code for failure of adequate protection. Secured creditors looking to protect their secured status must consider how the value of their collateral may change as the business plan is implemented and the case evolves.